Online Stock Option Trading | The Safe Place to Take Big Chances (Guest Post)
Online stock option trading, to me, is the first and last step on the investing ladder a retail investor should endeavor to climb. Stock trading (despite the hype) is far too inefficient for the average small cap retail investor. On the other hand forex trading, with its ginormous leverage ratios, may have all the promises of riches one might just as well get from a genie in a lamp but with it comes the ginormous risk associated with margin calls and losing far more than you invested.
What Makes Online Stock Option Trading Different?
In a word, control. More accurately, risk control. The advantage the options trader has over the forex trader or margin stock investor is the ability to make either a “long” (call) or “short” (put) play on the market by taking a LONG position – i.e. BUYING (a.k.a. CONTROLLING) a call or put contract. Doing so puts an inherent limit on the maximum size of the loss on the investment (100%). Where else can you get the potential gains associated with the implied leverage of an options contract without there being the implied risk of being “short” somewhere else. Confused? Maybe an example will help.
Consider a typical forex position. In order to make a trade, a trader enters the market and wants to take a position in the EUR/USD (euro vs US dollar) and thinks the euro will strengthen relative to the US dollar, the trader would then want to go LONG the euro vs. the US dollar. What the trader knows (and the neophyte investor may not understand) is that by going LONG the euro vs. the dollar the trader has also effectively gone SHORT the dollar relative to the euro.
Seems Obvious, So What’s the Big Deal?
The big deal in being short ANYTHING is that the trader in that position may not be able to control his or her own destiny vis a vis losses. When combined with the seductiveness of using “maximum leverage” the size and scope of losses can be astronomical. A trader with $1000 to invest at a forex broker can leverage that to purchase up to $100000 worth of a given currency. Just for the sake of simplicity let us say the trader went long the dollar vs. the euro when the two were at par (trading 1 euro costs 1 US dollar – seems like ages ago, no? but I digress…). What would the trader’s (capital) losses (not including interest, fees, etc.) be with the euro now costing $1.40?
Staggering Losses for the Highly Leveraged Small Cap Trader
In this scenario it is likely the trader’s broker would have liquidated his position long ago and completely wiped out his account, but for the sake of instruction let’s carry the computations through to their gruesome end.
A trader with a $100000 long position in US dollars borrows (and hence OWES) 100,000 euros to his or her counter-party. When the market for the EUR/USD moves to $1.40, it means that to purchase 1 euro now costs $1.40. The long USD trader OWES 100,000 euros, which will now cost $140,000 to buy. Given the trader only had $1000.00 capital in his account to begin with – he only has $101,000 ($100,000 worth of currency bought plus his $1000 initial capital) with which to buy those 100,000 euros. He’s $39,000 in the red!
How Might Someone Using Online Stock Option Trading Create the Same Leverage without the Risk?
The math behind options trading can be a little hairy, but bear with me, ok? Remember from our glossary that contracts typically consist of 100 shares, right? Good. We’ll use the same $1000 of initial capital as before, and we’ll create 100:1 leverage – as before.
In this case we’ll use KSWS (KSwiss – a well known clothing manufacturer) – which today is trading near enough to $10/share that we’ll call it an even $10 for simplicity. The $10 strike price April 2010 call options (Symbol: SWUDB.X on yahoo finance) are trading near enough to 0.10/contract that we’re going to pretend that you can get them for 10 cents. It wouldn’t happen in reality prices the way they are this moment but we need simple numbers to make a point.
How Online Stock Option Trading Creates Implied Leverage
Online stock option trading is done where a trader buys a call (expecting a rise in price) or put (expecting a fall in price). Today we’re going to buy either 100 shares of KSWS directly (cost: $1000) or $1000 worth of call option ticker SWUDB.X. Our $1000 will buy 100 call options of SWUDB.X. Remember that each contract represents 100 shares so 100 shares/contract x 0.10/share = $10/contract. $1000 / $10/contract = 100 contracts – the equivalent of 100,000 shares (100 contracts x 100 shares/contract = 100,000 shares).
As you can see our buying power using online stock option trading can be made into 100:1 leverage by choosing a contract with a price 1/100th of the underlying share price. If the stock you wish to buy is trading at $27/share and you want to create a position of 100:1 leverage using an online stock option trading position, you need to find an option on that stock trading for $0.27/share. Make sense?
What Happens When the Stock Tanks?
In fairness to our doomed forex trader, let’s examine what happens to the leveraged options trader when the price of KSWS drops 40%, down to $6/share. In this case the option expires out of the money (see glossary) and is worthless. The bad news is that the entire $1000 investment is lost.
The good news is that still puts him $39,000 AHEAD of the bankrupt forex trader.
And that, ladies and gentlemen, is why I prefer to take my risks making leveraged trades using an online stock option trading platform rather than trading forex, or stocks on margin, or futures, or any other such foolishness. Fickle markets can make fools of anyone. Best to let your foolishness be limited to the size of your capital stake, rather than risk losing your home or life savings to a margin call.
About the Author
Steve Wise is a lifetime stock and options trader with a Master’s Certificate in Finance and Investments.